3.1.7.1 - Income, wealth and inequality

Income is a flow; wealth is a stock

Income measures resources received over time, while wealth measures assets held at a particular date after allowing for debts.

Income is a flow, such as £30,000 earned in a year. It includes wages, profit, interest, rent, pensions and transfers such as cash benefits. Wealth is a stock: the value of accumulated assets minus liabilities at a date. Assets can include property, financial investments, physical possessions and pension rights. A £200,000 home with a £150,000 mortgage contributes £50,000 of net property wealth, not £200,000.

Income and wealth connect without being interchangeable. Saving part of income can add to wealth; assets can generate rent, dividends or interest. Asset prices can rise without a household receiving a corresponding income flow. A retired owner may have high housing wealth and modest income; a graduate may have high earnings and little net wealth after debts. Selling an asset changes its form into cash and is not automatically new income equal to the sale price.

Disposable income is income available for spending and saving after direct taxes, including cash benefits. Comparing living standards also requires considering household size and needs. An equivalised income adjusts for household composition so that a large family is not treated as equally well off as a single person merely because their total incomes match. Wealth also differs in liquidity: a house or future pension right cannot always finance today's shopping without a sale, borrowing or access restrictions.

Why distributions differ and persist

The distribution of income and wealth reflects market rewards, institutions, household circumstances and accumulated advantages.

Earnings differ because skills, experience, productivity, hours and occupations differ. Demand for a scarce skill can raise its wage; unemployment or underemployment reduces earned income. Bargaining power, trade unions, monopsony, discrimination and access to jobs can change rewards even for similarly productive workers. Household income also reflects the number of earners, pensions and transfers. Income inequality is therefore broader than wage inequality.

Wealth depends on past saving, inheritances, gifts, asset ownership, asset-price changes and debt. A household that owns rising-value property benefits while a renter does not automatically receive that capital gain. Compound returns can enlarge differences: someone with a large portfolio can reinvest more investment income. This does not mean every wealthy household's assets always rise, or that debt is always harmful; productive borrowing can build future earning capacity.

Age matters because assets often accumulate over working life and are drawn down later. Nevertheless, a life-cycle explanation does not establish that everyone starts with the same opportunities. Inheritance and unequal access to education, credit and networks can transmit advantage across generations. Taxation, cash benefits, public education and healthcare influence the disposable-income distribution and people's opportunities to earn or accumulate assets.

Distinguish mechanisms from evidence. A correlation between parental wealth and a child's future income fits several possible explanations, including education, networks and inheritance. It does not measure the independent causal effect of each. Relevant evidence would compare otherwise similar circumstances or examine a specific change affecting access to an opportunity.

Averages and quantiles reveal different things

An average describes a central value, while quantiles show where people or households sit in a distribution.

The mean is total income divided by the number of observations. The median is the middle observation when incomes are ordered; with an even number, average the two middle values. In a positively skewed income distribution, a few very high incomes can pull the mean well above the median. The median is often more useful for describing a typical household, while the mean relates total income to the number of households. Neither tells us the whole distribution.

Consider five illustrative, comparable households with annual disposable incomes of £10,000, £12,000, £14,000, £16,000 and £48,000. Total income is £100,000, so mean income is £20,000. The median is £14,000. If only the richest income rises to £73,000, the mean becomes £25,000 but the median remains £14,000. A rising mean does not prove that most households gained.

Quintiles divide an ordered population into five equally sized groups, each containing 20%. Deciles divide it into ten groups of 10%. A group's share of total income differs from its share of people: the richest quintile contains 20% of people but may receive 45% of income. Quantile boundaries, such as the income needed to enter the richest decile, are not the same as a group's average or total share.

For an illustrative distribution in which the richest fifth receives 45% and the poorest fifth 5%, the ratio of their total incomes is $45/5=9$. Because the groups contain equal numbers, their mean incomes also have a ratio of 9. Compare like units, the same population and the same income definition. A nominal income rise can coexist with lower purchasing power if prices rise faster; a change in group averages need not track the same households over time.

Lorenz curves and the Gini coefficient

A Lorenz curve shows the cumulative income share received by successive shares of the population, ordered from poorest to richest.

The horizontal axis is cumulative population percentage; the vertical axis is cumulative income percentage. The 45-degree line represents complete equality: the poorest 40% receive 40% of income, for example. With positive incomes ranked from low to high, a more unequal distribution has a Lorenz curve farther below this line. It starts at (0%, 0%) and ends at (100%, 100%).

The following data are illustrative. Each quintile has 20% of the population. Add the successive income shares to obtain the cumulative values; do not plot each group's separate share as though it were cumulative.